I'm attracted to banks' low valuations, but repulsed by where we are in the economic cycle. Defaults are going up from here, against the backdrop of an asset base devalued by 475 basis points of interest rate hikes in 13 months. If lots of people start losing their jobs later this year, the level of deposits could fall, which from the bank's perspective is similar to a wave of demands for cash. That leads to more recognition of losses, which leads to worse ratios, which leads to the need for banks to pay ~5% interest to borrow from the Fed.
The Federal emergency loan program should eliminate the risk of further bank runs. I think it will, anyway. Yet I don't think most banks have positive equity right now, except for the fictitious values of "held to maturity" assets on their balance sheets. When banks are typically leveraged 15:1 or 20:1 or so, it doesn't take a large loss to flip equity negative.
The case for buying banks (or insurance companies, or mREITs) right now is the expectation that when things turn around, they'll have solid earnings and re-flation of their asset base due to falling interest rates.
The conundrum for bank bulls is how could we possibly get falling interest rates without the kind of recession that will drive up delinquencies and drive down deposits? It seems like the most unlikely combination of interest rate outcomes and economic outcomes is the one where the economy does well AND interest rates fall. All 3 other possibilities on that grid are bad for banks.
Even then, let's look at the happiest scenario - where rates fall and the economy does well (i.e. mild & short recession or no recession). I think it's implausible to expect the FFR to return to a 0.25% upper bound, but we might go from today's 5% to, let's say, 3% in an uber-optimistic view. For a bank that held an average duration of 8 years, these rate cuts would amount to a roughly 14% increase in the value of assets held across that timespan.
Of course an investor could get that return by investing in treasuries directly, rather than via bank shares or bonds, and avoid the risk of rising defaults. The reason to buy banks is that you'd get this tailwind PLUS the discounted future earnings of the bank (discounted at a lower rate too!). So when we pay for bank equity right now, what we're actually paying for is the option value of the bank in the soft landing scenario. In any other scenario, share prices and fundamentals will be cheaper in the future and today's deal is a value trap.
The more likely scenarios involve higher default rates for
cars,
mortgages, and
corporate bonds and leveraged loans. Default rates are already increasing in some of these areas.
Bank stocks could be seen as a leveraged option on treasury rates going down, but that would be an over-simplification because defaults will wipe out much of their value in most scenarios where rates go down.
Bulls are reasoning that most banks will survive the next recession. Regardless of which scenario unfolds, the question is will they become stuck in a zombie state, unable to make risky loans, all crowding into the same handful of safe haven assets with minimal returns, and waiting years for old "held to maturity" bonds to mature off their books? The banks which dilute their stockholders with new equity offerings might be the only ones to escape such a cycle.